Mark Twain once lamented that reports of his death had been greatly exaggerated. So too have reports of impending doom in commercial real estate, particularly within the retail sector.
While more than $700 billion in commercial real estate loans in the U.S. are considered underwater, a vast majority of them are still performing and current and will continue to be so in the future.
According to New York-based retail research firm Real Capital Analytics Inc., the total cumulative outstanding distress of loans in the retail sector stood at $40.3 billion at the end of 2009, with nearly half of that ($20.4 billion) in the form of commercial mortgage-backed securities (CMBS) loans in the hands of special servicers.
But simply because a loan is in distress does not mean foreclosure is imminent. With a tactical eye towards the future and a comprehensive knowledge of the past, lenders, borrowers and potential investors will be able to see the opportunities.
Back in the early 1990s, the last period in which the industry was inundated with distressed real estate, many lenders and special servicers opted to foreclose when borrowers defaulted. But they learned quickly that a great deal of money was being left on the table. So-called grave dancers purchased massively discounted properties and flipped them at a profit once the market recovered. Today, note holders have vowed to do things differently and have a number of potential remedies:
Selling the loan: Lenders may choose to sell notes at a discount, typically garnering 55 cents to 75 cents on the dollar. Lenders take a loss, but avoid lengthy and expensive foreclosures. There is often no upside for borrowers as the new note holders will typically begin foreclosure proceedings.
Creating good notes from bad: Lenders can also chose to bifurcate debt. As an example, a lender could split a troubled $30 million loan into two new loans — a $21 million prime loan and a $9 million troubled loan. The lender could retain the performing $21 million note and sell the $9 million troubled note at a discount. Again, the new note holder will generally foreclose.
Sharing the pain: As another option, a lender can write down troubled loans, for example taking a troubled $30 million note down to $26 million. But in order to lower the loan-to-value ratio to a reasonable 75 percent to 80 percent, the borrower must come up with an additional $5 million in equity. This option remains an anomaly as few borrowers can come up with additional capital.
The white knight: As a last strategy, the borrower, the lender and a third partner could share the pain. Here, a lender writes down a $30 million note on a property to $26 million while a white knight puts up $7.8 million in equity. The resulting note for the borrower becomes $18.2 million, but in exchange the white knight receives the cash flow generated from the property. The lender avoids foreclosure, the white knight assumes control of the property and the borrower receives a “hope note” in which the proceeds are split with the white knight if the property increases in value. This is one of the most frequent options pursued today.
In place of foreclosure proceedings on CMBS loans, many special servicers have moved to install court-appointed receivers. This has become increasingly common in both the retail and multifamily sectors.
When a CMBS loan goes into receivership, the lender quickly gains control of the asset, preserves its value and is allowed to retain the assumable debt in the event of a sale. The borrower also receives immediate relief of liability for funding operating expenses and debt service, avoids a protracted legal battle and preserves their reputation.
By using innovative solutions and learning from the past, lenders can transform the distressed assets of today into the opportunities of tomorrow.